Leases: Ghost Leverage Exposed

Lease structures matter more than ever when the rest of the margin equation gets stressed. This is when the aggressive models are exposed, and the conservative models are rewarded.

Those who have been tracking my analysis know that I’m pretty much obsessed with operating lease structures for retailers. Not out of morbid curiosity, but by the way that striking such agreements as it relates to duration, and varying step-up factors can meaningfully distort current earnings streams. Here are two Exhibits showing two overriding themes. 1) Minimum lease obligations over 5 years versus current operating margins, and 2) The incremental change in that rate over the past 2 years. Some interesting conclusions…

1) Those with the healthiest lease obligation ratio include Timberland, Warnaco, Philips-Van Heusen, Columbia, Payless, Hibbett, Carter’s Nike and VF Corp. These are companies that have a call option to alter lease terms (i.e. lower near-term payments, but higher escalators, or for example), and improve operating margins. Whether or not this strategy is wise, it is an option.

2) The companies with the poorest positioning are Dick’s, DSW, Skechers, and BJ’s. I’d even highlight Coach and Abercrombie as high margin, low flexibility portfolios. That’s not to say that there is massive risk to those models, but simply that if business slows meaningfully, their respective options are more limited to tweak the portfolio to ease a margin pinch.

1) In looking at the incremental change in ‘flexibility ratio’ over the past 2 years, there are some clear standouts. Timberland, Finish Line, Columbia, Ralph Lauren, Van Heusen, Warnaco, and Hibbett all look particularly good, with improvements of 10 points or more.

2) On the flip side, Skechers, Quiksilver, Carter’s, VF Corp, Nike, and to a lesser extent Abercrombie all register at the opposite end of the spectrum. These companies have been taking up forward minimum obligations relative to current payments. This is not always bad, as it might be explained away by a change in business mix (i.e. JNY’s got worse bc it divested Barney’s). But overall, it is a way for a company to boost current margin run-rate, and is a key factor to watch.

Positive Standouts: Timberland, Columbia, Ralph Lauren, Phillips-Van Heusen, and Hibbett.

Negative Standouts: Skechers, Dick’s, DSW, Carter’s VF Corp and Nike.

Click on charts below for a larger view, or email me for the Excel file.

Eye on Behavioral Finance: Confidence

“I always knew I was going to be rich. I don’t think I ever doubted it for a minute.” -Warren Buffet

Investors have a love / hate relationship with confidence. On one hand, being confident in your analysis, process, and team is critical to making sound and successful decisions. On the other hand, overconfidence, especially to the point of hubris will lead to risk taking, which can ultimately lead to losses that become insurmountable.

The word hubris finds its root in the Greek work hybris. In ancient Greece, hybris referred to actions of those who challenged the gods or their laws, which led to their eventual downfall. In fact, hybris was considered the greatest sin of the ancient Greek world. The story of Icarus is one of the most telling examples of hybris in ancient Greek mythology. Despite repeated warnings from his father Deadalus, Icarus was overcome with the giddiness of being able to fly and flew to close to the sun. He burnt his feathers, was no longer able to fly, and fell into the sea.

In investing it is critical to be aware of overconfidence and protect against the development of hubris, particularly after a recent period of success in the markets. This success can lead to, naturally, a feeling of overconfidence and more rampant risk taking. This psychology predicament is well known in many fields. In the military, this is referred to as “victory disease” as successful military commanders have a tendency to demonstrate poor judgment after a series of military victories. Napolean’s ill fated invasion of Russia is, perhaps, one of the more notable examples.

From an investment perspective, overconfidence creates at least three fatal flaws: miscalibration, better than average effect, and illusion of control.

- Miscalibration occurs when investors overestimate the precision of their knowledge and tend to use confidence intervals that are too narrow. In a paper by Graham and Harvey, CFOs were given a multi-year survey and asked to give their 80 percent confidence interval for stock market close over the next year. When over 4,300 forecasts were measured against the actually results, only 30.5 percent, or less than a third, were accurate within the 80 percent confidence interval.

- Better than average effect occurs when people grossly misjudge their abilities. This was highlighted in a recent Washington Post poll in which, “94 percent of Americans said they were above average in honesty, 89% in common sense, 86 percent in intelligence, and 79 percent in looks.”

- Illusion of control involves the belief that one may be able to influence random events. In a famous study by Langer and Roth, participants were asked to flip a coin ten times with rigged results. When asked how they would do in a game of 100 flips, those who started with a series of wins expected to do much better and, additionally, almost forty percent believed they would get better with practice.

Overconfidence is much more than just a behavioral economic trait that we need to be aware of it, it also has an actually physiological foundation in the way of dopamine, which is a chemical that the body generates to reward “success” and by creating a feeling of pleasure. Keith has previously posted on the impact of dopamine and Richard Peterson summarizes this effect well in his book “Inside the Investor’s Brain”:

“The dopamine-based reward learning process encodes a profitable pattern of behavior. Subsequently, however, highly profitable traders may have difficulty maintaining the same level of attention to risk management because of a chemical shift in their brains. They become slightly bored and push the limits of their abilities and risk exposures in order to continue to feel challenged. The combination of low relative dopamine levels during during trading (because they have already learned profitable techniques) and elevated norepinephrine levels provokes increased boredom, distractibility, and scanning for new opportunities.”

Too much success, in effect, can change an investor’s brain and lead to chemically based overconfidence that will lead to excessive risk taking.

To be clear, as we attempted to highlight in the quote from Buffet at the start of this note, confidence in your abilities is also critical in the achievement of investment success, and success in life broadly. If you do not believe in your process and your team, then your ability to make timely decisions will be limited, but this confidence must be framed in rationality. In effect, you can only achieve what you believe you can achieve. As Jack Schwager wrote in Market Wizards:

“One of the most strikingly evident traits of all the market wizards is their high level of confidence . . . But the more interviews I do with market wizard types, the more convinced I become that confidence is an inherent trait shared by these traders, as much as contributing factor to their success as a consequence of it . . . An honest self appraisal in respect to confidence may be one of the best predicators of trader’s prospects for success in the markets.”

A starting place of any success, whether in investing or otherwise, is in confidence, but at the same time we must be very wary of the pitfalls of overconfidence. A method we use at Research Edge is to keep investment journals. While this seems trivial, it is also a way to quickly and accurately verify when your success is based on skill versus luck. It also provides us the ability to look back and learn from our mistakes.

Daryl G. Jones
Managing Director

Quote Of The Week: John Mack, CEO, Morgan Stanley

"MUFG’s investment is a powerful endorsement of the tremendous value in the Morgan Stanley franchise, but the caliber and commitment of our people give me even greater confidence about the future of this Firm,”...
-John Mack, 2008

This, of course, is Morgan Stanley’s version of a white knight, MUFG (as in Mitsubishi Financial)... as in the Japanese firm that cut their outlook by another 50% versus expectations this week and announced that they need to find another 990B in Yen of liquidity...

The aforementioned quote by Mack, was not one he made this week. He said it earlier in the month, when guiding the Street to whatever light he saw in levering MS to another over-geared bank. There have been multiple points in this economic downturn's history that the said leaders of "Investment Banking Inc." and the US Treasury (are they one and the same?), have issued global investors short sighted perceptions versus reality. Our promise is to ‘You Tube’ them.

If the excuse is that “no one could have proactively seen this financial tsunami coming”, we’re short that. If there is no proactive risk management or research process, we’ll just call it out for what it is – being wrong.

We hear, quite often, that Mack is a good guy. This quote is unfortunate.

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Chart Of The Week: A Great Week For Capitalists!

This was a great week for capitalists!

Our chart of the week is the +14.6% squeeze rally in the S&P500 (from the intraday Tuesday low of 845 to Friday’s closing high of 968). The “I am going to cash” crowd’s call to arms looks a little late now. The US market has closed UP, on a week over week basis, in 2 of the last 3 weeks.

This was a great week for America’s new capitalists –being liquid and long trumps being levered with debt.

CHUX – Removing CHUX from the dreaded list

I’m officially removing CHUX from the Restaurants @ Research Edge bankruptcy list. The remaining players on the list include DIN, RUTH and RT.

On the 3Q98 conference call CHUX’s management said they would limit capital spending to only maintenance capital spending. The balance of the cash would be used to reduce debt by the end of fiscal 2009. Unfortunately, that alone would not eliminate the potential of being in default of their bank credit agreement if business trends remained on the current trajectory.

The only answer is a liquidity event for the company. Currently, the company owns the land and building on 100 stores, of which 15 are not pledged as collateral to the banks. I believe that company will do a sales leaseback on the 15 properties to generate cash and repay the bank debt. The transaction will be dilutive to EPS as the lease payment will be higher that the interest on the bank debt, but the risk of default is eliminated. The sale-leaseback will not happen all at once, but over the next 3-4 months.

A liquidity that eliminates the potential for default will be a significant catalyst for short covering.


Light sweet crude, the primary grade traded on the NYMEX, is on its way to the biggest single month decline since futures contracts for it started trading in 1983. The sellers are focused squarely on demand: concern over the cooling global economy is trumping OPEC’s saber rattling, at least for now.

We continue to think oil is something to trade here, not to own.

Our near term buy trade level is 59.62
Our near term sell trade level is 67.14

We would keep stop losses in place in either direction.

Keep a trade a trade to stay in the game.

Andrew Barber

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